China and India: The race to growth
The world’s two biggest developing countries are taking different
paths to economic prosperity. Which is the better one?

Diana Farrell, Tarun Khanna, Jayant Sinha, and
Jonathan R. Woetzel

The McKinsey Quarterly, 2004 Special Edition :
China today

First it was China. The rest of the world looked on in
disbelief, then awe, as the Chinese economy began to take off in the
1980s at what seemed like lightning speed and the country positioned
itself as a global economic power. GDP growth, driven largely by
manufacturing, rose to 9 percent in 2003 after reaching 8 percent in
2002. China used its vast reservoirs of domestic savings to build an
impressive infrastructure and sucked in huge amounts of foreign
money to build factories and to acquire the expertise it needed. In
2003 it received $53 billion in foreign direct investment, or 8.2
percent1 of the world's total—more than any other country.

India began its economic transformation almost
a decade after China did but has recently grabbed just as much
attention, prompted largely by the number of jobs transferred to it
from the West. At the same time, the country is rapidly creating
world-class businesses in knowledge-based industries such as
software, IT services, and pharmaceuticals. These companies, which
emerged with little government assistance, have helped propel the
economy: GDP growth stood at 8.3 percent in 2003, up from 4.3
percent in 2002. But India's level of foreign direct investment—$4.7
billion in 2003, up from $3 billion in 2002—is a fraction of
China's.

Both countries still have serious problems: India
has poor roads and insufficient water and electricity supplies, all
of which could thwart its development; China has massive bad bank
loans that will have to be accounted for. The contrasting ways in
which China and India are developing, and the particular
difficulties each still faces, prompt debate about whether one
country has a better approach to economic development and will
eventually emerge as the stronger. We recently asked three leading
experts for their views on the subject; their essays may be accessed
on the pages that follow or by clicking on the titles below.

—Jayant Sinha

Notes
1 The United Nations Conference on Trade and Development (UNCTAD)
database on foreign direct investment.

China and India have followed radically different
approaches to economic development. China's resulted from a
conscious decision; India more or less happened upon its course. Is
one way better than the other? There is no gainsaying the fact that
China's growth has rocketed ahead of India's, but the conventional
view that the Chinese model is unambiguously the better of the two
is wrong in many ways; each has its advantages. And it is far from
clear which will deliver the more sustainable growth.

Together with Yasheng Huang, of the Sloan School
of Management, at the Massachusetts Institute of Technology (MIT), I
have argued that these approaches differ on two dimensions. First,
the Chinese government nurtures and directs economic activity more
than the Indian government does. It invests heavily in physical
infrastructure and often decides which companies—not necessarily the
best—receive government resources and listings on local stock
markets. By contrast, since the mid-1980s the Indian government has
become less and less interventionist. The second dimension is
foreign direct investment. China has embraced it; India remains
cautious.

These differences have an
impact on the types of companies that succeed and, I would argue, on
entrepreneurialism. Let's look first at what kinds of
companies thrive. China trumps India when it comes to industries
that rely on "hard" infrastructure (roads, ports, power) and will do
so for the foreseeable future. But when it comes to "soft"
infrastructure businesses—those in which intangible assets matter
more—India tends to come out ahead, be it in software,
biotechnology, or creative industries such as advertising.

Thus manufacturing companies whose just-in-time
production processes rely on efficient road and transport networks
fare poorly in India. But businesses that are unconstrained by
shortages of generators and roads flourish. Soft assets underpin
even the Indian car industry. Unlike China's car sector, which has
expanded as a result of big capital investments from multinational
companies, India's has succeeded on the back of clever designs that
make it possible to produce cheap indigenous models. India actually
sends China high-value-added mechanized and electronic components
whose production depends more on know-how than on infrastructure.

Moreover, many hard-asset companies in China exist
because the government funnels money to them. The government can do
this because it intervenes in domestic capital markets. In India
there is no such government intervention. Hence successful companies
tend to cluster in industries where capital constraints are less of
an issue. You don't need a deep reservoir of capital to start a
software company; you do for a big steel plant.

The Indian government's lower level of
intervention in capital markets and its decision not to regulate
industries that lack tangible assets (software, biotech, media) have
created room for entrepreneurs. Entrepreneurial activity is fueled
both by incumbent (often family-owned) enterprises and by new
entrants. The former use cash flows from diverse existing businesses
to invest in newer ventures. In biotechnology, however, Biocon
emerged from pure entrepreneurial effort, as did Infosys
Technologies in software. Similarly, hundreds of smaller versions of
companies such as Infosys and Wipro Technologies have no government
links, unlike so many of China's successful companies.

Although India's stock and bond markets are hardly
perfect, they do on the whole support private enterprise. Here too,
entrepreneurialism has played a part, even improving India's
institutional framework. Take the Bombay Stock Exchange (BSE),
founded about 130 years ago and until recently the most inefficient
entity imaginable. It has become radically more efficient in the
past decade as a result of the competing efforts of an enterprising
former bureaucrat named R. H. Patil. With technological inputs from
around the world and some fancy footwork to dodge entrenched
interests at the BSE, in 1994 he started a rival institution, the
state-of-the-art National Stock Exchange of India, which now has
more business. In China, by contrast, the government tries to make
stock markets successful by command, with predictably little to show
for its efforts. There has been little competition indeed between
the Shanghai and Shenzhen exchanges.

Good hard infrastructure and the Chinese
government's decision to welcome foreign investment make it
reasonably easy for multinationals to do business in China, and
since they bring their own capital and senior talent, they do not
have to rely heavily on local institutions. China has no shortage of
homegrown entrepreneurial talent. But indigenous companies have a
much tougher time, hindered as they are by inefficient capital
markets, a banking system notorious for bad loans, and the fact that
local officials rather than market forces largely decide who
receives funding.

China and India both have the ability to keep
growing in their own very different ways for a decade or so. The
Chinese government's intervention in the economy—including the
decision to welcome foreign direct investment—has brought a material
improvement in the standard of living that India hasn't enjoyed. It
may also be that each country has chosen the path best suited to its
own historical circumstances. But the pros and cons of these two
development models should be studied, and it is fair to ask whether
China's approach will hamper its future economic development.

Huang and I believe that the presence of so many
self-reliant multi-national companies has partly relieved the
Chinese government of pressure to develop or reform the institutions
that support free enterprise and economic growth. And the fact that
many domestic investments still are not allocated through sensible
pricing mechanisms means that China wastes many of its resources.
Productivity and long-term economic growth, as we all know, thrive
on competition, which is all too often stifled by government
intervention.

When the two countries are compared, it is easy to
forget that India began its economic reforms more than a decade
later than China did. As India opens up further to foreign direct
investment, we might well discover that the country's more
laissez-faire approach has nurtured the conditions that will enable
free enterprise and economic growth to flourish more easily in the
long run.

About the AuthorTarun Khanna is the Jorge Paulo Lemann professor at the Harvard
Business School.

China: The best of all possible
modelsIn an efficient market, the private sector is
better than governments at allocating investment funds.
But China isn't an efficient market, and India has relatively little
investment funding.

Jonathan R. Woetzel

Finding fault with China's approach to economic
development is easy: cyclical overcapacity, state-influenced
resource allocation, and growing social inequalities are just a few
of its shortcomings. But it's hard to see how any other model could
have given the economy such a powerful kick start.

The Chinese government manages the development of
enterprises with a view to driving economic growth. You can be a
small entrepreneur in China, but if you want to be big you will have
to get money from a government-affiliated source at some point.
Government officials essentially have the power to decide which
companies grow.

In achieving the objective of growth, this policy
has been tremendously successful. China has quickly built industries
large enough to drive its economy. Take the auto industry, now an
important contributor to the manufacturing sector. Only 20 years
ago, China had no auto industry to speak of; there were a few
manufacturers of trucks but none of passenger cars. To get started,
the government decided that in a high-scale, high-tech industry,
some foreign company—in this case, Volkswagen—had to come in and
show local ones what to do. Because most local companies were
state-owned 20 years ago, Volkswagen was hooked up with a
state-owned company.

You might argue that this development model has
thwarted entrepreneurship. But there weren't any entrepreneurs in
the industry at the time. There were no private companies that could
partner with Volkswagen, let alone compete with it. The government
simply said, "We want China to modernize. We want the Chinese
economy to grow. We don't have the companies we need to make that
happen, so we're prepared to do what it takes to create them."

The capital-intensive auto plants built with
foreign partners in China as a result of its development policy may
have no particular productivity advantage over the plants they might
have built at home. But all of the spending by the big car companies
has paid off.

Moreover, local, privately owned automakers such
as Chery Automotive and Geely Automotive are beginning to thrive. A
generation of entrepreneurs has put to good advantage the skills and
training that the foreigners provided, so that Chinese companies now
put together cars of reasonable quality much more cheaply than
foreign automakers can. At present, domestic players benefit from
the price umbrella that the foreign ones provide. But these smaller
fry are now making cars for $2,000, which means that any company
that has high cost structures will eventually suffer. With lower
tariffs on the way because of China's accession to the World Trade
Organization, and with new competitors proliferating, the automotive
industry is heading into a classic price war that only the fittest
will survive. This is precisely what happened in the consumer
electronics industry, where competition led to the emergence of
successful Chinese companies that operate globally. I think that in
five or ten years' time, at least a third of the Chinese auto
industry will be completely private—nothing to do with the current
state players. And this will all have started with the state saying,
"We want to build a car industry."

Looking at industry more broadly, inefficiencies
and cyclicality have resulted from the fact that many funding
decisions are driven at the local-government level. Local officials
have GDP growth as a political-performance target, so many of them
look for the biggest investments they can make to push along the
regional economy. Like stock market investors pursuing the latest
speculative fad, they have created a lemming effect, with lots of
unsound investments, whether in aluminum smelters, residential real
estate, or TV factories. The outcome tends to be waves of
overcapacity as investments are made right up to—and sometimes way
beyond—the point where it is patently obvious that the economics
cannot justify them.

But remember that the essential mechanism of
economic reform in China has been the encouragement of competition
among provinces and municipalities. Until the 1980s there was no
such thing in China as a national company. Everything was local.
There was no single legal entity that operated more than five
kilometers (about 3.1 miles) from its headquarters. With the removal
of internal trade barriers, local entrepreneurs and their government
backers invested to build scale and attack neighboring markets. Yes,
this does lead to overcapacity and price wars. But over time—and
relatively short periods of time, too—all that cyclicality also
leads to shakeouts that the most competitive enterprises survive.
These enterprises, thanks to their national scale and real
competitive advantages, no longer depend on local-government funding
and can now start to compete for the long term, both domestically
and internationally.

That has certainly been the story in consumer
electronics, where the top three players in personal computers
control 50 percent of the domestic market, and in beer, where the
top ten own 30 percent. It is starting to be the story in heavy
industries, where companies such as China Qianjiang own 40 percent
of the motorcycle market and Wanxiang dominates its niche in
automotive components (see "Supplying auto parts to the world,"
available on mckinseyquarterly.com on September 16). Interestingly,
it is not the foreign companies but the locals that tend to be the
winners of the consolidation wars. The beer industry is a case in
point: most foreign brewers, unprepared for tough domestic
competition and rapid consolidation, entered and exited in the
1990s.

Moreover, I don't believe that foreign direct
investment is linked to the development of China's capital markets
or to a reform of the banking system. Multinationals account for
only 15 percent of fixed-asset investment, so they don't drive the
economy to a very great extent. China must rely on its own domestic
financial resources to finance growth. As a result, the country's
capital markets are being developed. And the government is fixing
the banks through tough higher reserve margins, branch-level changes
in performance management and incentives, and more flexible
risk-based pricing.

As for the oft-stated view that China is trying to
create global state-owned champions, it is at least partly a myth.
The government does want to develop strong Chinese companies, but it
does not expect them to be state enterprises, which are inefficient
by definition. Indeed, it is now telling them that if they want to
grow, they will have to get listed on the stock market. The
government's policy for the first 20 years of its reform program
was, "Let's do what's needed to establish markets." Its policy for
the next 20 years will be, "Let's get out of those markets." The
global Chinese companies of tomorrow will be competitive, mostly
listed, and entirely commercial in their aims and purposes.

Ultimately, you have to ask whether the
inefficiencies of the Chinese approach outweigh what it has achieved
for the economy overall. The answer, I think, is no. The government
still controls most of the country's financial resources and has
been reasonably good at allocating them—that's why the economy has
grown so fast. Compared with the private sector in an efficient
market, the government is no doubt worse at allocating funds. But
China is not an efficient market, and the Indian model—essentially
one with relatively little investment funding, whether by the
government or the private sector—could not have achieved as much
growth for the Chinese economy as the approach China's government
actually took. The Indian model might not be adequate for India's
economy either: the country's family-owned businesses and other
private investors may be good at deciding what makes a sound
investment for them, but they have not spent enough money to drive
the kind of growth seen in China. It would not surprise me at all to
see investment in India rise dramatically as foreign and domestic
investors alike begin to recognize its potential going forward.

About the Author
Jonathan Woetzel is a director in McKinsey's Shanghai office.

Sector by sector
The strength of the Chinese and Indian economies will actually be
decided at the industry level.

Diana Farrell

The answer to the question, "Which is the better
approach to economic development?" is not to be found at the
national level. You have to look at what's going on in individual
industries. And when you do, you find that supportive government
policies that encourage competition drive good performance. Both
China and India have some sluggish, inefficient industries that are
heavily regulated and lack competitive dynamism. But both countries
also have successful industries that thrive unfettered by poor
regulation.

The McKinsey Global Institute has long argued that
the key to high economic growth is productivity and that the main
barrier to productivity gains is the raft of microlevel government
regulations that hinder competition. This idea is well illustrated
in the case of India.

At the high end of India's productivity spectrum
is the information technology, software, and
business-process-outsourcing sector. It's a big success story,
having created hundreds of thousands of jobs and billions of
dollars' worth of exports. As a new sector—and one whose potential
the government, in my view, failed to recognize early on—it has
avoided stifling regulation. IT, software, and outsourcing companies
are exempt from the labor regulations that govern working hours and
overtime in other sectors, and they have been allowed to receive
foreign direct investment, which is prohibited in retailing, for
example. Without this foreign money, it is debatable whether the
sector could have taken off. By 2002 it already accounted for 15
percent of all foreign direct investment in India.

In the middle of the spectrum is the auto
industry, which has seen dramatic change since the government began
to liberalize it in the 1980s. By 1992 most of the barriers to
foreign investment had been lifted, and this made it possible for
output and labor productivity to soar. Prices have fallen and, even
as the industry has consolidated, employment levels have held steady
thanks to robust demand. Nonetheless, with tariffs on finished cars
still relatively high, automakers remain sheltered from global
competition and the sector is less efficient than it could be.

At the low end of the spectrum is the consumer
electronics sector, which, despite the lifting of foreign-investment
restrictions in the early 1990s, is still burdened by tariffs,
taxes, and regulations. As a result, Indian consumer electronics
goods can't compete internationally and prices for local consumers
are unnecessarily high. The performance of India's food-retailing
industry is even worse. Partly as a result of a total ban on foreign
investment, labor productivity is just 6 percent of US levels.

Now look at China, which also has some reasonably
liberalized and highly competitive industries, including consumer
electronics, in which labor productivity is double that of its
Indian counterpart. Over the past 20 years, the industry has become
globally competitive through a combination of foreign direct
investment and intense competition among domestic companies. It is
also remarkable for the relatively liberal approach the government
has taken to regulation—probably because of a failure to see its
growth potential. Today China makes $60 billion worth of consumer
electronics goods a year.

The performance of China's auto industry—which was
considered a strategic one and remains tightly regulated because of
the government's desire to bring in technology and investment—is
less clear-cut. The market has been opened up to foreign automakers,
consumer demand has grown enormously, and prices have dropped. Yet
the sector shows how government intervention can thwart the
potential of foreign direct investment. Foreign automakers can
invest only in joint ventures, they have to buy components from
local suppliers, and tariffs shield the market from imports.
Competition is beginning to increase as private companies grow
stronger. But for the time being, the productivity of foreign joint
ventures in China is low compared with that of plants in Japan or
the United States—astounding given China's low labor costs.

Since there are such big differences in the
performance of different sectors within the same country, it makes
sense to compare the performance of India and China at the sector
rather than the national level. In IT and business-process
outsourcing, India is so far ahead of the game that China can't do
anything during the next 10 or 15 years that would bring it close to
catching up. In consumer electronics, however, China dominates, and
India won't provide serious competition during the next 10 years.

The auto sector is a toss-up. India's competitive
forces have driven an enormous amount of innovation in the sector.
Low-cost labor has been used instead of expensive automation, and
local engineering talent has developed innovative new products such
as the Scorpio—a sport utility vehicle that sells for a fraction of
the price of an equivalent car in the United States. In China, large
amounts of foreign direct investment have built a big industry, but
regulation has so far limited its competitive potential.

It is far from clear which economy will emerge as
the stronger one. The foundations of robust, sustainable economic
growth must be built at the industry level, on the back of high
productivity, which is achieved when governments ensure a level
playing field through sound regulation and remove the barriers that
stifle competition. Both China and India still have ample
opportunity to help their industries and economies thrive.

About the Author
Diana Farrell is the director of the McKinsey Global Institute.